Returns and allowances are not subtracted under section 6501(e)(1)(A)(i)

Plain-English summary

Chief Counsel Advice considered how returns and allowances affect the six-year assessment period under IRC § 6501(e)(1)(A)(i), which applies when omitted gross income exceeds 25 percent of the amount reported. The advice concluded that the special definition of gross income in that provision uses the total amounts received or accrued from sales of goods or services, without reducing that amount by returns and allowances. Returns and allowances may still reduce gross income under the general rules, but they are disregarded for this specific 25-percent omission calculation. The advice illustrates the distinction with examples involving discounts, rebates, and returned merchandise.

Ruling snapshot

• Question: Should returns and allowances reduce gross receipts when calculating gross income under IRC § 6501(e)(1)(A)(i)?
• Outcome: Advice given
• Key authorities: IRC §§ 41(c)(7), 44(d)(5), 61(a)(2), 448(c)(3)(C), 6501(e)(1)(A)(i), 1244(c)(1)(C), and 1362; Treas. Reg. §§ 1.61-3, 1.263A-3(b)(2)(ii), 1.446-4, 1.448-1T(f)(2)(iv), and 1.1244(c)-1(e); Bencivenga v. Commissioner, T.C. Memo. 1989-239

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201023053
       Release Date: 6/11/2010
       CC:PA:01:RJGoldstein
       POSTN-105123-10

UILC: 6501.07-00, 6501.07-10

date: April 29, 2010

 to:   Kathy Sexton
       Technical Services Group Manager
       (Small Business/Self-Employed)

from: Blaise Dusenberry
Senior Technician Reviewer
(Procedure & Administration)

subject: IRC Section 6501(e) Question

       This memorandum responds to your request for advice.

                                               ISSUE

       Are amounts received or accrued reduced by returns and allowances when determining
       gross income for purposes of I.R.C. section 6501(e)(1)(A)(i)?

                                          CONCLUSIONS

       When determining gross income for purposes of I.R.C. section 6501(e)(1)(A)(i), the total
       amounts received or accrued from the sale of goods or services should not be reduced by returns and allowances.

                                               FACTS

       You have requested assistance on the manner in which a taxpayer accounts for returns
       and allowances in determining gross income for purposes of I.R.C. section
       6501(e)(1)(A)(i). Section 6501(e)(1)(A) provides that if a taxpayer omits from gross
       income an amount properly includible therein which is in excess of 25 percent of the
       amount of gross income stated in the tax return, the tax may be assessed, or a
       proceeding in court for the collection of such tax may begin without assessment, at any
       time within 6 years after the return was filed.

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Section 6501(e)(1)(A)(i) specifically addresses cases involving a trade or business and
includes a special rule for determining gross income. Under this subsection, gross income is
defined as the total of the amounts received or accrued from the sale of goods or services (if
such amounts are required to be shown on the return) prior to diminution by the cost of such
sales or services. Returns and allowances (and other income) are not specifically mentioned.
You have asked if in a case involving a trade or business, a taxpayer’s gross receipts and sales
should be reduced by returns and allowances when calculating gross income.

In some cases, the 25 percent omission computation hinges on how to treat returns and
allowances. For example, Exam may make adjustments in both gross receipts and returns and
allowances. If gross income is determined by reference to gross receipts without subtracting
returns and allowances, the omission does not exceed 25 percent. However, if returns and
allowances are subtracted from gross receipts to determine gross income, without reduction for
costs of sales, then the omission exceeds 25 percent and the six-year statute under § 6501(e)
applies. The following chart illustrates this scenario:

                      Per Return         Per Exam          Adjustment

Sch C Gross 500,000.00 600,000.00 100,000.00
Receipts
Returns & (50,000.00) (5,000.00) 45,000.00
Allowances
"Net Gross Receipts" 450,000.00 595,000.00 145,000.00

25% of Gross Receipts at 500,000.00 is 125,000.00. The adjustment
amount is 100,000.00. IRC 6501(e) would not apply.

25% of "Net Gross Receipts" at 450,000.00 is 112,500.00. The
adjustment amount is 145,000.00. IRC 6501(e) would apply.

                             LAW AND ANALYSIS

In general, taxpayers who sell goods or provide services compute gross income through
a basic computation. This computation results in gross income by subtracting returns
and allowances and cost of goods or services and adding other income to gross
receipts and sales. This computation is illustrated in IRS Form 1120, U.S. Corporation
Income Tax Return, Form 1120S, U.S. Income Tax Return for an S Corporation, and
Form 1040 Schedule C, Profit or Loss From Business. Tax Court decisions likewise
acknowledge that gross receipts are reduced by returns and allowances in computing
gross income. See Friedmann v. Commissioner, T.C. Memo. 2001-207 (Returns and
allowances are taken into account in computing gross income and differ from
expenditures that are business deductions.). Under the Internal Revenue Code and its

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corresponding regulations, returns and allowances are sometimes but not always
subtracted to determine “gross income” pursuant to special rules and definitions.

Section 61(a)(2) provides, in part, that gross income means all income from whatever
source derived, including gross income derived from business. Section 1.61-3 of the
Income Tax Regulations provides that in a manufacturing, merchandising, or mining
business, “gross income” means the total sales, less the cost of goods sold, plus any
income from investments and from incidental or outside operations or sources. Thus,
while cost of goods sold is subtracted from total sales to determine gross income,
returns and allowances are not specifically mentioned in section 1.61-3.

A number of other Code provisions and regulations address the issue of whether a
taxpayer reduces its gross income by the amount of returns or allowances for purposes of
those sections. For example, section 41(c)(7), pertaining to the credit for increasing
research activities, provides that gross receipts for any taxable year shall be reduced by
returns and allowances made during the taxable year. Similar provisions that require a
subtraction of returns and allowances from gross receipts include sections 44(d)(5) and
448(c)(3)(C). Section 1.263A-3(b)(2)(ii) provides that gross receipts does not include
amounts representing returns or allowances. Likewise, section 1.448-1T(f)(2)(iv)
provides that gross receipts include total sales (net of returns and allowances) and all
amounts received for services.

There are also a number of regulatory provisions providing that gross receipts are not
reduced by returns and allowances. For example, section 1.1244(c)-1(e) of the
regulations provides that gross receipts are not reduced by returns and allowances for
purposes of section 1244(c)(1)(C) (Losses on Small Business Stock) in determining
whether a corporation’s stock is “section 1244 stock”. The same is true for section
1.1362-2(c)(4), which provides that gross receipts, for purposes of determining
Subchapter S election status, are not to be reduced by returns and allowances, cost of
goods sold or deductions.

The Tax Court has held that returns and allowances are subtracted from gross receipts
to determine gross income. In Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707
(1956), the taxpayer recorded sales of milk on its books at the authorized list prices set
by the state but paid allowances, reductions and rebates back to some of its customers
and entered them on its books as advertising to disguise the true nature of these
payments. These allowances were made pursuant to informal agreements with its
customers. The taxpayer contended that the allowances should be applied to reduce its
gross receipts and sales on the theory that the milk was actually sold for the agreed net
prices. The court looked to the agreement of the parties at the time of sale to determine
the net sales price and held that any amount given back to the customer is considered an
allowance not includible in gross income. Id.

The general definition of gross income and the statutes, regulations, and caselaw on the
subject, however, do not apply for purposes of section 6501(e)(1)(A)(i). This section

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creates its own special definition for gross income by defining it as the total of the
amounts received or accrued from the sale of goods or services, if such amounts are
required to be shown on the return, prior to subtracting the cost of sales or services.
This definition is synonymous with gross receipts and sales as the amount includes both
money received and money due from sales during the taxable year (accounts
receivable). There is no case law on point that definitively indicates whether this
amount should be reduced by returns and allowances to calculate gross income for
purposes of section 6501(e)(1)(A)(i).

Our determination that amounts received or accrued should not be reduced by returns
and allowances is based on a plain reading of the statute. The specific language states
“the total of the amounts received or accrued from the sale of goods or services (if such
amounts are required to be shown on the return) …” We believe that under a plain
reading of the statute, the referenced amount is the amount reported on the business
return as gross receipts and sales. See Bencivenga v. Commissioner, T.C. Memo.
1989-239 (For section 6501(e)(1)(A)(i), “[i]n the case of a trade or business … gross
income is the same as gross receipts undiminished by the cost of sales or services.”).

We have included below three examples to help clarify how returns and allowances are
accounted for when computing gross income generally and for purposes of section
6501(e)(1)(A)(i). These examples illustrate: (1) a discount reducing gross receipts and
sales, (2) an allowance reducing gross income but not reducing gross receipts and
sales, and (3) a return reducing gross income but not reducing gross receipts and sales.

  1. Business A sells 100 units with a “ticket” price of $100 for $80 each. The
  amount received or accrued from the sales of the units that is required to be
  shown on Business A’s return is $8,000. The $20 discount is not an allowance
  because the amount paid was $80 not $100. $8,000 is reported on the line for
  gross receipts and sales but the $2,000 is not reported on the line for returns and
  allowances.

  2. Same facts as in example 1 except Business A sells all 100 units to Business
  B for $100 each. At the time of the sale, Business A agrees to give Business B a
  $2,000 rebate for buying all 100 units. Business B pays $10,000 and then
  receives a check for the $2,000 rebate. The $2,000 rebate is an allowance on
  Business A’s tax return that reduces gross income but it does not reduce gross
  receipts and sales. $10,000 is reported on the line for gross receipts and sales
  and $2,000 is reported for returns and allowances.

  3. Same facts as in example 1 except Business A sells all 100 units to various
  customers for $100 each. Twenty customers subsequently return their units.
  Business A must report $10,000 as gross receipts and sales (regardless of
  whether payment was received). The $2,000 of returned merchandise is
  reported as returns and allowances thereby reducing gross income.

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The gross receipts and sales reported on Business A’s return is the equivalent of the
total amounts received or accrued from the sale of goods or services for purposes of
section 6501(e)(1)(A)(i). The returns and allowances will reduce Business A’s gross
income on its tax return under the general rule for computing gross income. However,
pursuant to the special definition of gross income under section 6501(e)(1)(A)(i), only
amounts received or accrued are considered and returns and allowances must be
disregarded (as well as cost of goods or services and other income). Accordingly, gross
income for purposes of section 6501(e)(1)(A)(i) is gross receipts and sales.

Please contact Ron Goldstein at (202) 622-4910 if you have any further questions.